Roth 401K Basics

My “invest in a Roth IRA or 401K” post from last week triggered a number of questions from readers.

I wanted to highlight and discuss one of those questions, in particular, as it’s a good one.

It comes from reader, Sandi, who writes in,

“I just started a new job and in 3 months I’ll have to decide between a regular 401K or a Roth 401K. The employer contributes 5% salary to either. I’d never even heard of a Roth 401K before. What are the major differences? Are there more benefits to one over the other?”

Great question, Sandi!

I believe that the choice between an IRA and 401K is pretty clear cut. However, the choice between a Roth retirement account and a traditional retirement account is always much more subjective.

I’ll discuss what considerations should go into the decision right after covering the basics.

What is a Roth 401K?

Roth 401K’s are relatively new in the world of retirement accounts. They were first introduced in the United States in 2006 and their adoption rate by employers was slow out of the gate, but now 70% of employers offer a Roth 401K.

A Roth 401K combines many of the benefits of the Roth IRA and the Traditional 401K.

You have the same 401K maximum contribution as a Traditional 401K while still having the tax now/no tax in retirement benefits of a Roth IRA.

Still, there are some important distinctions to be made and a Roth 401K might not be the best for everyone.

Are Roth 401K Matching Contribution Tax Free?

This thought crossed my mind a few years ago when I found out my employer was adding a Roth 401K option: “Wow, I can get post-tax matching contributions to a Roth 401K! More free 401K match dollars!”.

It’s probably the most common Roth 401K misconception there is.

Unfortunately, Roth 401K matching funds are not post-tax dollars.

When you open a Roth 401K, your employer will open a separate traditional 401K. All matching funds that go into that traditional 401K are pre-taxed, meaning that you are not taxed now, but you are taxed on withdrawals in retirement.

What is the Maximum Employee and Employer Roth 401K Contribution?

Same as the Traditional 401K, the maximum Roth 401K contribution for employees is $19,000 in 2019, or $25,000 for those 50 and over.

The maximum employer contribution for a Roth 401K is also the same as the traditional – $56,000 in 2019 (combined with employee contribution) or 100% of the employee’s salary (whichever is less).

Roth 401K or Traditional 401K?

Getting back to the original question, there is no right answer on the Roth vs. Traditional 401K question.

Many financial pundits recommend young professionals go with the Roth because they claim you’ll be in a lower tax bracket now than when you are in retirement due to lower earning power now. As such, they argue that it’s to your benefit to get taxed now (Roth) vs. being taxed in retirement (Traditional).

There is an assumption that you will have so much saved for retirement that you’ll actually be earning more income on your retirement account withdrawals than the income you are making right now. That’s not always going to be the case. In fact, for many, the opposite will be true. Painting broad brush statements like that are dangerous.

Others argue that tax rates will only go up in the future, so you might as well pay lower taxes now. This is another dangerous assumption to make. Short-term budget shortfalls may fuel this thought. However, when you look at the historical income tax rate, taxes are near the lowest point since 1931! The long-term trend has been downward, even with a little bump in the last few years to the top tax bracket. And with one political party making it their entire platform, that may never change.

Traditional IRA, a new employer's Traditional 401K, or a Roth IRA (pay taxes)

Pay Taxes At

Time of Contribution

Withdrawal in Retirement

Can Begin Withdrawing Earnings Without Penalty

At age 59.5

At age 59.5

Taxes in Account

No taxes on dividends, capital gains, or interest

No taxes on dividends, capital gains, or interest

To understand the differences between the two, it’s often most easily observed through a chart.

As you can see, Roth and Traditional 401K’s are very similar, with the exception of the pre/post tax difference. Unfortunately, only you can answer the question of whether or not you want to be taxed now or in retirement.

It’s a lifestyle choice based on your long-term vision for your finances.

Can’t figure it out? You could always split your contributions between the two!

Roth 401K Discussion:

Does your employer offer a Roth 401K?

Do you invest in a Roth 401K over a Traditional 401K or vice versa? Why?

Related Posts

45 Comments

Joe

Great article, however in your “Roth 401K vs. Traditional 401K Chart” I feel like you left one important fact out. Roth 401(K) earnings are non-taxable when you take the money out when you retire, but Traditional 401(K) earnings are taxable. I think that’s a pretty huge difference that should not be overlooked and one of the main advantages of a Roth 401(K) over Traditional 401(K)

But this difference is basically a wash. If you were to take out the same amount of money from your paycheck, part of the ROTH money would go to taxes. If your tax bracket stayed exactly the same and the growth in the two accounts was the same, the amount of money taken out from the traditional account as taxes would be 25% of the total balance.
$1000 invested $750 invested
100X growth 100X growth
$100,000 $75,000
75,000 after taxes 75,000 tax free

As pointed out, a major flaw is that the tax bracket will most likely not be constant, so who do you trust? It will never be lower? Or it can only go higher?

I’m going to have to agree and disagree with you. In your example you are right you end up with the same amount of money at the end of it, however you end up spending $25000 in taxes vs $250 in taxes. If you were to invest the same dollar amount in the Roth and Traditional you would end up with more money in the end. So in a case where you could max out the Roth or Traditional 401(k) the Roth option would make more sense if you used your constant tax brackets and identical growth.

But that’s not a valid comparison. You can’t compare making the same dollar contribution to a Roth 401(k) as you do in a traditional because it would take more dollars to fund the Roth – it’s after tax money. One thing to consider though is that your 401(k) income in retirement will count as income and could affect your Social Security (yeah like that’s going to be around) and other government benefits that are income based whereas the Roth “income” would not count which could mean you get more of those other benefits.

Although it is rare, I have heard of (never worked for) companies that contribute much higher amounts than mine. Typically, these are companies thay doesn’t offer a pension, but have the desire to help more with their employees’ futures. New employees at my company basically get a 9% match on a 6% investment, while I get 4% and a nice pension. I’d rather habe my deal right now, but their’s is better than nothing.

Also, $175 per week is only $9,100. Maxig out would be just under $337. I guess you are maxing out you match, which is very smart, but you can always theoretically save more.

Good comparison, but you’re missing one small detail from your chart – the early withdrawal penalty of 10% applies to only the earnings in the Roth 401(k), but to the entire balance in the Traditional 401(k). That makes a huge difference if you’re considering moving to another country and taking your entire 401(k) balance with you.

If I was moving to another country (it is a possibility if I get laid off, run out of unemployment, and lose the house), I would definitely leave my accounts back in the U.S. and keep them active due to the tax penalties.

If you’re not American, it’s a lot easier to navigate the 10% early withdrawal penalty when you leave the country than to navigate the taxation laws and tax treaties for American retirement accounts in your country, if you have no plans to return to the US.

Another plus to the Roth 401k is that you can theoretically put in 25-33% more. This is only important if you are maxing out a traditional 401k. The downfall is that your MAGI is not decreased with a ROTH 401k, so some tax breaks may not be available any more (for examplet, the student loan interest deduction).

My company has a Roth 401k and I contribute 10% to it. My employer contributes an additional 9% to a traditional 401k.

But going back to the original question:

“I just started a new job and in 3 months I’ll have to decide between a regular 401K or a Roth 401K. The employer contributes 5% salary to either. I’d never even heard of a Roth 401K before. What are the major differences? Are there more benefits to one over the other?”

If the employer is contributing to a 401k, it is going to be pre-tax in a traditional 401k.

Hunter, you’re right it’s important to have diverse retirement funds, but don’t confuse how they’re administered with how they’re invested.

IRA, Roth IRA, 401K, Roth 401K are just ways to administer them.

Mutual funds, stocks, bonds, CDs, etc. are how they’re invested.

Personally, I prefer index mutual funds as they’re diverse and follow various market indexes (S%P, Russell 2000). They pretty much follow the market or certain parts of it and have low management fees. You don’t have to worry about who is the best stock picker (manager) — if the market’s up, you’re up, if the market’s down, you’re down!

Sparky, I think you may be the one confused here. She’s talking about tax diversification, not investment or administration. It’s one of the most valid points behind Roth savings vehicles and probably the most compelling reason to use them.

You are forgetting one important line in your table, “Can begin withdrawing contribution without penalty.” Though never recommended, Roth 401k contributions can always be withdrawn, but to get at Traditional contributions you have to wait until 59.5 or do SEPP plan.

As you said, there is no one right answer. I will say that people make this more complicated than it needs to be. Contribute to your 401k up til the employer match! What you do next depends on how much more you are able/willing to save. If you can afford to max out both your 401k and Roth, then do so in order to receive the maximum benefit. If you can’t, then leave enough to max out your Roth. Essentially you can even use this as an emergency fund after 5 years, since you will then be able to remove your OWN contributions penalty free, however, you have to leave the gains within the account in order to not be penalized.

My husband and I live on his income alone. When his employer started offering a Roth 401k I immediately signed up. I thought it was a simple choice since we are in the 10% income tax bracket. I highly doubt our tax would be lower than that in the future. However, after we had a child and we started qualifying for income based credits like EIC and saver’s credit, I realized I had been too hasty. By putting 4k in a traditional we could qualify for 50% saver’s credit and increase the amount for EIC. I figured that between the lower tax bill and the increase in credits that we would get a return of 38% for every dollar we put in the traditional. Not bad! Yet, things changed again when my husband took a second job where he works from home. It will probably increase our household income by 50%. We will no longer qualify for low income credits and we are switching back to the Roth. Even if I were in the highest income bracket I would probably still do a Roth and max it out because after tax dollars are worth more than pre-tax dollars.

I think one of the biggest benefits of a Roth account is psychological: When I look at my Roth 403b statement, I know that every single penny there is mine and when I start withdrawals in retirement I won’t have to guess and how much it’s “actually” worth after taxes.

I will also agree that a big benefit is having Roth contributions (but not earnings) being tax-free, so I basically have a second emergency fund at my disposal.

Another thing to consider is required minimum distributions. I’m not sure specifically what the rules are for a Roth 401k, but I know if you roll the Roth 401k dollars over to a Roth IRA, there are no required minimum distributions, but if you have a traditional IRA, you start running into required minimum distributions at age 70.5. Having the flexibility to choose when to take distributions and not have to worry about possible tax implications of large pretax distributions on things like Social Security and Medicare is another point in favor of going Roth.

I’m 24 years old and I started a Roth IRA while working as a financial advisor after college graduation at age 22. While I have yet to start a 401(k), the model that I always professed to clients was based on diversifying your tax vehicles, to include both traditional and Roth models:

– Always start with a Traditional 401(k). While you may lose some of the psychological benefit of knowing the money is all yours on the tailend, and it doesn’t seem to make sense paying so much in taxes on the backend when you could pay less on the frontend, ultimately it makes more sense to invest more money now, since more money makes more money (think: economy of scale). This means that Traditional and Roth models would not theoretically grow at the same rate.
– Invest in the 401(k) initially only up to your employer’s required maximum match.
– MAX OUT a Roth IRA at this point – you will be helping give yourself a hedge against future taxes by complementing 401(k) distributions with tax-free Roth IRA distributions, giving you what you technically need in total distributions but keeping taxable distributions in a lower bracket (EXAMPLE: instead of taking 100% of your needed distribution in retirement from your taxable traditional 401(k), you take 70% from your trad 401(k) and the other 30% from your Roth IRA). Depending on your income projections, it’s also important to max a Roth IRA early, due to MAGI restrictions.
– Max out your Trad 401(k) once you have accomplished the preceding. This will help to lower your MAGI, allowing you to continue contributing to your Roth IRA longer, and will obviously help you take advantage of having a larger chunk of money get invested.

Given that the Roth 401(k) is not something I frequently had to answer questions on or work on with clients, I don’t know if it would be possible at some future point when you can no longer contribute to your Roth IRA because of MAGI restrictions to start up a Roth 401(k) along with your Trad 401(k) simultaneously and balance your contributions between the two to achieve the same desired outcome of complementing taxable distributions with non-tax distributions.

There’s also the argument that you could stick with maxing out your Trad 401(k) at that point and start putting more money into Permanent Insurance (through one of the big three, Northwestern Mutual, NY Life, Mass Mutual, where it’s actually profitable), either through a normal 65 Life policy (stable 6% growth, not exposed to market volatility) or a Variable Life policy, which will act more like a Roth IRA (post-tax contributions, tax-deferred growth, and tax-free distributions in the form of a “policy loan”, same basic market exposure).

I think all of the above is sound advice. The maxing out of a traditional 401k to lower your MAGI is one strategy;however, one significant drawback to any 401k plan is that you are limited to the investment options in the plan. I suppose this is not that big of a deal if the investment options are decent but I would look at other sources of investment opportunities first.

I am glad you mentioned this because I was wondering why no one brought in the amazing vehicle that is the Roth IRA. I have personally decided to contribute to my 401k up to the company match, and then max out my Roth IRA.

The Roth IRA gives SO many more possibilities. You can go a LOT more risky if you want, medium risk, or you can just invest in safe funds; it is completely up to you! The risk diversification to me is great; especially with the ability to trade options in Roth IRA’s. To me, the 401k is 40 year pretax CD account where my company also gives me free money if I put a little money in myself.

I originally thought “The Roth IRA is great, so the Roth 401k must be great too!” But the single fact that you are limited to the same levels of risk as a traditional 401k makes it unappealing to me.

ALSO, keep in mind that if you want to contribute in a Roth 401k to get company match, you must contribute the same dollar amount as if you contributed in a traditional 401k. That means, for example, if you normally contribute $5000 PRE-tax for company match, you must contribute $5000 POST-tax in a Roth to get the SAME company match. That is a waste of tax dollars for me.

If you have extra $$ to contribute to retirement, you are probably in a pretty high tax bracket. I would continue to contribute to a Traditional in order to lower your MAGI now, and when you’re retired and your tax bracket is lower (hopefully), you withdraw at a lower tax bracket.

Rebuttals/Comments are welcome! I would rather someone show me the holes in my thought process now rather than learn the hard way later in life because I never saw the holes earlier!

I think your logic is spot on. I didn’t even think of the matching aspect of a Roth 401k but that is another important distinction that few people probably take into consideration. Plus, the flexibility of the Roth IRA is much better than the inflexibility in the Roth 401k if you ever need to draw from it. Great post!

This logic is spot on. Just want to add that 85% of Americans are in a lower tax bracket when they retire vs. when they are working. So if you think that is going to be your situation then you will want to max out your traditional 401K before adding to a Roth IRA. Better to lower your taxable income now when you are in a higher bracket than when you retire and are in a lower tax bracket. – You will be paying less taxes on the withdrawals in retirement. Now if you think you will be one of the 15% of Americans that will make more money and be in a higher tax bracket when you retire vs. when you are working then you will want to max out your Roth 401K or Roth IRA first. Then if you have extra money contribute to the traditional 401K or traditional IRA. Finally, the problem with all of this logic is we never know what the government is going to do with the tax policy/rates in the next 30 years which when I plan on retiring. That is why I think having a blend of the two adds tax diversification to your retirement portfolio.

Completely false – 85% of Americans are NOT in a lower tax bracket at retirement (particularly the ones who read this article). And additional taxable income from your IRA or traditional 401k increases not only the tax you pay on those distributions, but also the tax you pay on Social Security.
Best move is to have both taxable and non-taxable accounts during retirement so that you can best determine your taxable earnings each year. Since 401k matches are automatically in a “traditional” non-taxable form, it often makes the most sense for people to diversify and have their own contributions at least partially in a pre-tax ROTH.

Only thing I would clarify is that the pre-tax piece in the last sentence. It is actually tax FREE. I do agree with your entire sentiment that tax brackets will fluctuate significantly depending on a lot of different factors. For instance, my wife and I live on quite a bit less than our salaries so we plow as much into a tax deferred account as possible since we feel our overall tax bracket will lower upon entering retirement. We do tax diversification with a Roth IRA and dump the remaining amount for retirement in a taxable account. Hopefully, when we are set to retire, we can maintain a low cost lifestyle (e.g. inexpensive or free hobbies) and truly be taxed at our current lifestyle. A lot can change until then so we have some tax risk figured in with diversification in vehicle but the premise remains the same. Tax deferred first up to a point and then supplement with tax free/taxable and/or social security.

One caveat to what I previously wrote. In #3, you may want to contribute to a traditional or Roth 401K – either option or a combination of the two, depending on what you feel is more beneficial to you. #3 should be the only point at which you consider which 401K to invest in. But it seems to me, doing #1 and #2 are still important to do BEFORE getting to that point.

I don’t know about the Roth 401K options, but if it comes to a Traditional Roth IRA account, I can tell you that in most situations you will want to max this out every year you can (after obtaining the maximum employee match in your 401K plan). The reason is that all earnings that you make on that Roth IRA are 100% yours tax free. For this reason, you also want to touch your Roth IRA accounts last. Why? Because you pay no tax on any earnings, so you want them to accrue the most to give you the greatest bang for your buck. Keep this rule when it comes to a traditional Roth plan: “First in; last out.”

Now, it seems as though any earnings on a Roth 401K, if I’m reading this correctly, are taxable (while the initial investment has already been taxed on the way into the account). If that’s the case, then you would want to first contribute the maximum you can into a Traditional Roth IRA BEFORE contributing to a 401K Roth account. So the order of precedence for investments (and this is a generalization, because of course everyone will be in a different tax situation) would usually be:

I think one important distinction is that the Roth 401k, including earnings, is NOT taxable (except for the employer match component) upon distribution. That being said, I don’t think you’d change your pecking order listed as any IRA option(traditional or Roth) will allow you to invest in a much broader investment options than being limited to the options of a 401k plan.

How about addressing the Social Security impact of the regular 401K (or IRA)vs the Roth accounts? I was just surprised to learn that when you draw Social Security and you have taxable income over $44,000 a year for a married couple, which includes distributions from 401Ks and IRAs, your Social Security is taxed at 85%! It is my understanding if your income is out of a Roth account then Social Security is not taxed at all.

One box that is missing from this is MAGI. I know that a traditional 401(k) reduces your MAGI but does a ROTH 401(k) reduce it too? the tax code doesn’t seem to seperate 401(k) contrabutions. Anyone know if I can reduce my MAGI by contributing to a ROTH 401(K)?

I mentioned this in a comment above, but I understand not wanting to read through all of the comments. The ROTH 401(k) does not reduce your MAGI, since this is the income that you are taxed on. If it did, it would basically be the traditional 401(k).

First a question – you are spot on when noting that many people investing in Roth 401Ks will get a surprise because they don’t realize that the company matching funds are pre-tax – and hence count as taxable income. However, I recently read that you can now convert a traditional 401k to a Roth 401k. If so, why not just convert those pre-tax matching dollars your company put into a traditional 401K over to your Roth 401K and pay whatever tax you have to now, thus avoiding the headache of factoring percentages in later on?

First: even though you are not be required to take any minimum distributions from a Roth IRA, you may be forced to take withdrawals from a Roth 401K based on your company’s policies not on your preferences. Of course, if you are faced with that then you could always roll it over to an IRA. However, the 401K does have slightly stronger legal protections (or so I’ve read) than an IRA has so leaving your money in a company 401K may have some minor legal pluses.

I have a self directed Roth IRA that I am garnering a 35% annualized rate of return. I would like to know if there is such an animal as a self directed Roth 401K? I am assuming that I can always convert a Roth 401K to my self directed Roth IRA at some point in order to obtain my larger returns. Any one have any info on this? Thanks!

FOLLOW 20SF ON:

LIKE 20SF ON FACEBOOK:

SEARCH THE SITE:

This site provides general info & entertainment & should not be considered financial advice. Consult an independent financial advisor for your specific situation. Per FTC guidelines, this site may be compensated by companies mentioned through advertising & affiliate partnerships.

Join 10,000+ wealth builders. Get new articles by email, for free.

Thank you for subscribing!

Oops... Please try again.

We respect your privacy. Your personal information will not be sold or shared.